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Forex Trading – What Is Forex Trading?
Forex or FX is simply short for foreign exchange, but refers more specifically to currency trading.
This is exchanging dollars for pounds, or euros for yen and so on.
The currency exchange markets are the largest, most volatile and among the most risky forms of trade in the world. Amounts exchanged are large, magnifying small price changes, and the total daily volume is in the range of two trillion dollars. Yes, that’s ‘trillion’… a two followed by twelve zeros!
There are dozens of markets, with the largest centered in New York, London and Tokyo. Although, ‘centered’ is slightly misleading, since there’s no physical exchange that trades currency – unlike the New York or London Stock Exchanges for equities (stocks).
Instead, the playground primarily of large institutions – international banks, insurance companies and governments via their central banks – currency exchange is carried out by phone and via computer networks, formerly all private or government but now including the Internet.
And that latter means of communication, along with changes in trading methods, is what makes possible the opportunity for the individual investor with less than a few million dollars to participate in the fast-paced, highly speculative game of trading one country’s money for another’s.
In order to play that game without getting immediately run over, the investor will need to learn some new terminology, do some research in new areas, find a broker who trades currency and stock up on some courage pills. Enormous sums are traded in forex and only commodities trading offers similar ease in feeling dumb and getting poor fast.
But losing money isn’t inevitable for the prepared investor.
An investor will need to become familiar with new phrases and quoting methods – pips, spreads, cable and the like. Calculations formerly carried out with ease will now need a little more thought. Everyone is used to their own currency and seeing a $10 stock go up by a dollar one immediately sees a 10% gain. Trading currencies requires a little more knowledge.
The prepared investor will need to expand the scope of his research. Finding out the likely future of a home-based business is complicated, but straight forward. Conditions in one or two sectors and a few economic indicators can be grasped without requiring a PhD in finance. Learning about the factors influencing the currencies of two or more countries is an order of magnitude more difficult.
And more interesting.
Fast pace, global scope, large liquidity and volume, and a dozen different ways to hedge your bets. Yeah, that sounds good. Gotta get some of that right away!
Forex Trading – Currency Trading vs Stock Investments
The title points up an important difference between forex and stock investing.
When buying stocks you’re making an investment in a company. Buying shares is short for ‘purchasing a share of ownership’. By contrast, no one is making an investment in Japan by buying yen. We leave aside politically motivated actions by large central governments. Currency is exchanged in order to facilitate the movement of goods and the payment of services between multiple countries, but that’s a relatively small percentage of the total $2 trillion daily volume. The largest amount is simple speculation.
Well, perhaps not very simple. Trading euros against dollars against yen against pounds against… in a twenty-four hour market with a dozen time zones… it gets complicated.
Margin differences between the two markets are enormous. Most stock brokers will leverage (lend investors money) up to 2:1. In currency trading 100:1 is common. Since price movements occur twenty-four hours per day every day, margin calls can occur while the investor is sleeping. That makes for a bad awakening.
Trading cycles are generally much shorter. Stock investments are made, even by professionals, on timelines of months or years. Currency trades are often completed within a day or even minutes. Yes, that happens in the equities markets, too. But, it isn’t the norm even though it’s more common than ever.
All these differences suggest some lessons for the investor interested in forex trading.
Do your homework.
Be aware of factors affecting currency rates. That includes not only the standard domestic economic indicators, but trade imbalance figures, central bank policy changes and others.
Watch the market.
Small, rapid changes can force your position into an area that motivates your broker to execute a margin call. Be prepared to cover your position or liquidate at times favorable to you. Know the broker’s margin call policy and practice. You’ll be required to sign a margin agreement when opening an account. Read it first.
When starting out, take advantage of the demos offered by most brokers. Execute paper trades – trades that don’t execute on the real markets – using the real currency figures.
Get a feel for the amounts, the percentage changes and get used to converting currencies from one country to the next. You should be able to estimate without much thought how much 1,000 pounds is in dollars at the current exchange rate.
Opinions and size don’t matter.
Unlike stock markets, the size and complexity of the forex markets makes it virtually impossible for any investor, no matter how large, to dominate the price. Program trading, fund trading and so on that can cause large movements in particular equities has a negligible effect on currency prices.
Similarly, analyst projections have much less influence in currency trading. Many will read eagerly some influential columnist’s opinion of the future of IBM. Opinions of that kind are largely discounted in currency trading.
It’s a different world out there.
There are around 4,500 stocks listed on the NYSE and 3,500 on NASDAQ. And many more on other exchanges. A few hundred are major players. By contrast, only a dozen currencies account for 99% of all trades. With four major markets trading twenty-four hours per day, the action is very concentrated.
No need to be intimidated though. Currency trading has moved in the last decade from the realm of the professional trading millions at a click to mini-accounts of $250.
Forex Trading – Trader Psychology
Professional athletes are often told by their coaches that their attitudes on the field can affect whether they win or lose. That’s even more true in Forex trading. It sounds like the standard motivational speech, but having the right frame of mind can definitely influence your trading results.
There are many aspects of Forex trading that are outside the investor’s control.
Forex market participants number in the millions – traders for the world’s largest banks, huge governments and individuals just like you. Unlike stocks, even the big traders have a tiny effect on exchange rates.
Even when setting interest rates and other actions that influence inflation, the largest governments can have no immediate impact on exchanges. The Forex markets are simply too large – $2 trillion daily – for any one player to dominate the action.
Trading strategies, which are essential, can increase the odds of making profits and help minimize or avoid losses. They give the knowledgeable trader that tiny edge that can make the difference between winning and losing on a given trade, or over time.
But before looking at market influences, and even before developing a set of technical strategies that help guide trading choices, the novice Forex investor has to honestly and objectively examine his or her own attitudes.
Forex is fast-paced, complicated and requires a well-thought out game plan. That game plan has to be executed with nerve and skill. Trading successfully in a demo account for several weeks is essential but can lead to unwarranted confidence. Traders who invest Monopoly money will often take chances, leading to successful trades, that they wouldn’t dream of taking with real money.
Real trading requires answering honestly a number of questions that can be difficult to answer objectively when the subject is the self-same trader asking them. What are your financial trading goals? Looking for a quick buck? Seek elsewhere. You will have losses that wipe them out. Looking for secure, low-risk capital accumulation? Try AAA bonds instead.
Forex trading can be simultaneously a stimulating intellectual game and an exciting adventure. The thrill of victory! The despair of (temporary) defeat! The mastery of the intricacies of Fibonacci, Parabolic SAR, Stochastic Oscillators and Doji Stars. All this, and much more, is part of Forex investing.
As a result, you will need to be very frank with yourself and decide how (and whether) you are prepared to deal with pressure and fear. Even professional traders do not have any certain system of ensuring profits and avoiding losses.
The pressure of deciding when to buy and when to sell is many times larger than in stock trading. The fear of loss is greater, in part because of the amplification provided by 100:1 or larger leverage.
Even winning can be problematic. With practice and persistence, provided you don’t quit too soon or run out of money too quickly, you will have periods when it all seems laughingly easy. That can lead to euphoria, which is great. But it can also lead to cockiness, which is fatal. Nothing will wipe out a trader quicker than arrogance. Confidence is essential, vanity is suicidal.
The other side of the coin to be avoided is too much second guessing. Successful trading requires bold moves based on sound judgment and confidence. Every decision is a small leap of faith, since no one can know in advance for certain what the outcome will be. Probability of one degree or another is the best that can be achieved.
All this will be accompanied by the fear of loss of capital, which often leads to panic selling in the face of what would have been a temporary price movement. It is of such panics that depressions are made, both economic and psychological.
Forex is a roller coaster ride. But if you have a good inner ear and a strong stomach, bolstered by the brain of a statistician and the nerves of a pro billiards player, you will be well suited to end the ride with full pockets.
Forex Trading – Understanding Currency Prices
Forex trading is always about buying one currency and selling another one simultaneously. The world of currency exchange, Forex (Foreign Exchange), employs terminology not used elsewhere in the investment world. Defining those terms, and providing a sample trade, will go a long way toward taking the ‘foreign’ element out of foreign exchange.
Currency trading is always done in pairs. In other trading, such as stocks and bonds, cash is exchanged for something else (a percentage of ownership, a promise to pay interest).
In Forex, cash is traded for cash. Euros are traded for dollars, dollars for yen, yen for euros and so on. There are dozens of trading pairs, just as there are dozens of currencies around the world that participate in the currency exchange markets.
The major players are US Dollar (USD), Euro (EUR), Australian Dollar (AUD), British Pound (GBP), Canadian Dollar (CAD), Japanese Yen (JPY) and Swiss Franc (CHF). Most of all daily transactions involve trading of these major currencies.
So, when reading quotes, investors will see prices listed as:
The currency listed on the left is called the ‘base currency’ (EUR & GBP) and the second is the ‘quote currency’ (USD).
The ‘bid’ is the price at which brokers are willing to buy the base currency. The ‘ask’ price is that at which brokers are willing to sell the base currency. The quotes are always listed from the brokers’ point of view. So if you (the trader) wants to buy the base currency the ask price will apply. If you (the trader) wants to sell the base currency the bid price will apply.
EUR/USD 1.1901/03 means
If you buy 1 EUR you will pay 1.1903 USD
If you sell 1 EUR you will receive 1.1901 USD
GBP/USD 1.7439/42 means
If you buy 1 GBP you will pay 1.7442 USD
If you sell 1 GBP you will receive 1.7439 USD
The difference between bid price and ask price at a single specific time is called ‘the spread’. The spread is measured in pips (price interest points). The ‘pip’ is often said to be the smallest increment by which the price changes.
If the bid price of the EUR/USD pair changes from, say, 1.1901 to 1.1902 that’s a single pip. That’s a (bid or ask) price at two different times. Remember not to confuse this difference with the spread, which is a difference between the bid and ask price at a single, specific time.
Forex Trading – Sample Trade
Currency trades are always done in pairs between the currencies of two different countries. Below are listed two sample currency pairs.
Taking the one listed in the first line, let’s look at how a sample Forex investment might evolve over time.
As shown in the price listing, the ask price for the EUR/USD currency pair is 1.1903. Remember the ask price is that at which brokers are willing to sell the base currency (EUR). In this example that means we can buy the base currency (EUR) for $1.1903.
The bid price is listed as 1.1901. Remember the bid price is the price at which brokers are willing to buy the base currency (EUR). In this example that means we can sell the base currency (EUR) for $1.1901.
Unless you have something that brokers are now beginning to offer called a ‘mini’ account, all trades are done in standard lots of 100,000 units. So, to get in the game, you (theoretically) have to shell out $119,030 to purchase one standard lot of 100,000 euros.
To professional currency traders, that’s a tiny amount of cash. To the average investor interested in Forex trading it’s enormous. That’s one of the reasons some brokers are beginning to offer ‘mini’ accounts. Mini accounts have much smaller standard lots, such as 10,000 units.
Even at 1/10th the standard size, that’s still a substantial investment for many investors. Even professionals will balk at having to come up with the full cash amount for large trades. Forex brokers deal with this problem by offering something called ‘leverage’.
Leverage is the ability to control much more than you own. Forex brokers ‘loan’ an investor typically up to 90% or more. It isn’t technically a loan. The 10% or less actually invested is regarded, in the industry and in law, as a ‘good faith deposit’. The investor is technically on the hook for the other 90% or more, but it’s very rare to press an investor for the money.
Instead, if the price direction moves in an unfavorable direction (for the investor) by a large enough amount, the broker simply liquidates the position and the investor loses! It’s important to realise this! A good broker will usually give the client a call and give him or her the option to input enough fresh cash to cover the shortfall.
Currency prices can change by significant amounts very quickly (that’s called ‘volatility’), though, so be prepared.
What might that look like in a realistic scenario?
Let’s look at the above example EUR/USD 1.1901/03. Bid price is 1.1901 and ask price is 1.1903 and suppose trades are done at 1:100 (1%) leverage. You decide to buy EUR. In the case of 1 standard lot of 100,000 units, you put up 1% of $119,030, or $1,190.30.
Let’s take a look at the profit potential.
Suppose the market moves to EUR/USD 1.1907/09. If you sell the euros at this point, the bid price will apply. In this case you make a profit of …
$119,070 – $119,030 = $40.
That doesn’t sound like much, but observe two things.
One, the initial investment ‘out of pocket’ was only $1,190.30, and 1% of $119,070 = $1,190.70, only a 40 cent! difference ($0.4). Yet the actual profit was 100 times that, $40. That multiplier effect on the actual profit is the result of leverage.
Second, price changes of a few pips can (and often do) happen in minutes in the Forex markets, and getting in and out doesn’t cost a formal commission. Brokers make money off the spread. Investors can get in and out quickly and accumulate large amounts of profit (or loss) in one day. Or, they can wait for wider swings – which also often happens in relatively short periods.
Welcome to the roller coaster world of investing: Forex!
Forex Trading – Market, Limit and Stop Orders
To understand limit and stop orders it’s best to contrast these with the ordinary (and still extremely common) market order. A market order is one that is placed by the investor to execute at the current market price whatever that is at the time it’s filled. It’s very important to keep in mind that in Forex, ‘current’ changes even faster than in the stock market.
As a result of the inherent high (relative) volatility of Forex, any market order can be expected to deviate from the price shown on the investor’s screen some of the time. When a stock trader requests a market order right this instant to sell Microsoft at, say, $28.25, he or she can expect to get that price very often. The odds of selling at exactly the price shown on the screen right now is smaller in Forex trading.
As a result, other order types are more common in Forex trading. The most common are limit orders and stop orders.
In essence, a limit order is a request to guarantee you will not sell for less, or buy for more than the limit price, or nearly so. No broker will guarantee execution at an exact price, though this is often achieved.
Suppose, for example, that you bought euros at $1.1905. The market then rises to, say, $1.1955. Placing a limit sell order on your euros at, say $1.1945 would allow you to lock in a minimum profit of 40 pips or better.
Alternatively, you may want to buy in at no more than a specified price. Suppose the market for British pounds (GPB) is currently at $1.7750, which seems too high to you. You could place a limit buy order to buy GBP at $1.7705. In other words you are telling the broker you don’t want to pay more for GBP than $1.7705 per pound.
If the time limit expires before the price drops or rises to the limit price, the limit order simply expires unfulfilled.
A stop order used to be more commonly called a stop-loss order. That type is still used, by that name, incidentally. That gives a clue to what stop orders are primarily for: to stop losses.
It’s what can or does happen before and after that makes the difference between a limit order and stop order. A limit order is an order to buy or sell AT a specified price or better. A stop order is an order to buy or sell ONCE a specified price is reached. After that it becomes a market order and is subject to fluctuation.
Suppose you bought euros, using dollars in your account, at the then current exchange rate of $1.1903. Now suppose, as often happens in Forex trading, the exchange rate changes to, say, $1.1888. The market appears to be on the way down. In order to protect yourself from either a) having to input more cash to cover the equivalent of a margin call, or b) enduring an even larger loss, you wisely put in a stop order.
You tell your broker you want to sell those euros once the exchange rate reaches $1.1803, for example. If during the trading period, the price reaches $1.1803, your euros will be sold at the market price saving you from incurring further losses.
Note that the price used for executing the order is the market price! This is the most current exchange rate at the time the order is executed and not necessarily the threshold specified in the stop order ($1.1803). This means you may only get $1.1802, or 1.1801, or 1.1800 or lower depending on what the market price is at the moment your order is executed.
To prevent this from happening the stop-limit order may be your best friend. It’s a combination of a stop order and limit order. Like stop orders, your order will be executed once the market reaches a specific price. Once that price is reached, it becomes a limit order, so your order will only get filled at the chosen limit price, or a better price if there is one available.
These are techniques every investor should very quickly adopt as a habit, most especially novice investors. Forex trading is a roller coaster ride. Don’t get thrown out of the car. Use a seat belt… Use limit orders and stop orders liberally in your trading strategy. Market orders are simpler, but much more risky. Control your investments.
Forex Trading – One Cancels The Other (OCO) Orders
There are many strategies for risk management in Forex trading, just as there are with any other investment. One of the simplest to learn and use is employing different order types. A stop-loss order can help you limit losses, for example. A limit order can lock in profit gained.
Beyond these simple types, there’s one that is only slightly more sophisticated: the OCO order (One Cancels the Other). It’s easy to use and can be even more effective than the simpler types in controlling risk or maximizing returns.
Suppose a currency pair such as USD/CHF is trading at 1.4625. That is, the dollar is selling for 1.4625 Swiss Francs. But, as is common in Forex trading, that exchange rate can change rapidly and by a large amount. If it were to fall to, say 1.4600 within an hour or even a day, an investor might want to issue a stop loss order at 1.4575.
That figure is low enough that a small, temporary price fluctuation won’t liquidate the position at an unfavorable price. Stop orders convert to market orders and are subject to fulfillment once the stop price is reached.
If the price drops 5%, you may not want to get out. But you want to limit the potential downside loss at some point. If it dropped 20% in a day, you might wish you had gotten out after a 10% loss.
Similarly, if the price were to rise to 1.4900 you’d be delighted. But not everyone can time the market perfectly. You don’t have the option of putting in an order that says ‘sell when the market price is at the peak of what it would be for the next three months’. Wouldn’t we all like to do that!
So you have to make a reasonable bet about where the peak is. Suppose the market starts to drop back. It could be a momentary fluctuation downward, or it could be the beginning of a precipitous drop. Since you can’t know which it is with certainty, you can lock in some profit by requesting a limit order.
If the market drops back to, say, 1.4725 your limit order can be executed and you realize a profit of 100 points. Not the peak, but much better than waiting any longer if the market were to continue downward.
Now for the best of both worlds. The OCO order allows an investor to request a broker to react to not just one condition, but to one of a pair of possible conditions. You place a stop order at, say 1.4575 AND a limit order at 1.4725 simultaneously. Whenever one condition is realized, the other part of the order is canceled.
In other areas of investment, this strategy is even used with different kinds of instruments. An OCO order might specify ‘Buy Microsoft at $28.00, or ARCO bonds at 115.25’. Whichever occurs first determines what is actually bought, stock or bonds, and the other part of the order is simply ignored.
Something similar can be done in Forex in which an OCO order is placed to buy euros at 1.1905 or Swiss Francs at 1.4700. Which types of ‘mix and match’ are available varies from broker to broker, and what type of account or relationship you have with them, as well.
Using OCO orders is just one more in what should be a whole toolkit of investing techniques. But it is one of the simpler ones to learn to use effectively.
If you’re a novice trader it’s wise to use the trial trading software available on a Forex website and get familiar with the different order techniques. Record the results over a few week period and compare to what they would have been with straight market orders. You’ll convince yourself experimentally that risk management and profit strategies actually do work.
Forex Trading – Spreads and Investment Costs
Novices considering currency trading will read that Forex brokers charge no commissions and cheer. But don’t be fooled. Whether anything in life is truly free may be up for debate, but one thing is certain: nothing in investing is.
Forex market makers and brokers make money from something called ‘the spread’. It’s important you understand how it works.
Suppose a trader is dealing directly with a market maker. A market maker is an individual or company that directly offers a currency pair trade, as distinguished from a broker who acts as an intermediary. The bid price is that which the market maker offers to BUY the base currency from the trader. The ask price is that which the market maker requires in order to SELL the base currency in exchange for the quote currency.
EUR/USD 1.1900/05 means
If you buy 1 EUR you will pay 1.1905 USD
If you sell 1 EUR you will receive 1.1900 USD
The difference between those two prices is called the SPREAD and it is how market makers (and, indirectly, Forex brokers) make a profit, in stead of charging commissions. In practice, for every seller there must be a buyer for any trade to take place. The broker, acting as an intermediary – unless he or she is also a market maker buying and selling for his or her own account – locates a trading partner.
If you are willing to sell euros at the exchange rate of $1.1900 the broker locates someone willing to buy them at $1.1905. The broker pockets the difference, in stead of receiving an explicit commission.
How does this affect you, the Forex trader? You are paying for the spread, in essence.
Suppose you were to accept the trade and sell euros for dollars. The bid price will apply so you receive 1.1900 dollars for every euro sold. Now suppose you wanted to immediately buy those euros back from your broker. The ask price will apply so you would pay a rate of 1.1905 dollars for every euro acquired. That difference, the spread, is measured in points or pips, in this case 5 pips.
That five point difference would result in an immediate loss to you, even though the exchange rate hasn’t changed by a single pip. You sold euros for 5 pips less ($1.1900) than you bought them for ($1.1905).
Calculated in terms of dollars rather than points, you would lose $5,000 on an immediate trade of 100 lots. $11,905,000 – $11,900,000 = $5,000. At 1/250th leverage, however, this equates to an actual ‘commission’ cost of $5,000/250 = $20.
It’s perfectly legal and ethical. It’s simply the cost (to you) of trading in foreign currency.
As a result of the spread, which accompanies every quote, traders must wait for the market to move by at least that amount just to break even. To profit, the exchange rate must move by more than the spread. Of course, while you wait, the exchange rate can move in either direction and may result in an even greater loss if you liquidate your position.
In our example, you sold euros at 1.1900 and will have to see at least a 6 pip change in ask price (from 1.1905 to 1.1899) before you can buy euros at a profit. Every currency pair price – the exchange rate – moves, by definition and convention, a minimum of 1 pip. You will never see a 1.5 pip change, for example. This minimum is a one point change in the last digit in the price quote.
Of course, actual trading is not so simple. That needn’t be bad, though. That can work for you. Brokers or market makers offer different amounts and types of spread to different customers at different times.
Spreads may, and often are, narrower for those who have a 100K account and larger for those with a mini account. You put more money into the game and you get a better deal. That’s reasonable and normal.
Spreads for a mini account may be as high as 10 to 15 pips, and as low as 5 pips or less for a 100K account. Large banks and institutional traders are typically the only ones to receive ultra-low spreads.
Also, many brokers differ in the terms under which they’ll offer variable versus fixed spreads. For example, a broker might offer a variable, and decreasing, spread as the notional amount of the trade increases.
As an example, you offer to buy 10 standard lots of euros (10 x 100,000 euros x 1.1905 $/euro = $1,190,500) and the spread is, say, 3 pips. If the deal were only for 1 standard lot (100,000 units) the spread might be 5 pips.
Note that because Forex trading is highly leveraged a trader may only have to input 1/250th of the actual amount of dollars. Even that low fraction still amounts to an investment of $4,762 ($1,190,500/250) for 10 standard lots. Though high, that amount is within the reach of many non-professional traders.
Spreads can differ due to a dozen different circumstances. Just as with bonds, mortgage lending and every other form of investing today, the variations are many. Spreads will differ from broker to broker and from trade to trade. They can depend (as we’ve seen) on the amount traded, the established relationship between broker and client, or recent volatility, or current liquidity… The list is endless.
As a result of this, it pays the trader to do some homework and shop around for brokers that offer their clients the best spreads, on average. But beware – cheaper is not always better. Fixed spreads are typically slightly higher than variable, but offer the insurance of locking in a known cost.
It does little good to get great (super-small) spreads if your broker’s execution times are typically bad or if trades are frequently rejected. You want trades made quickly so they can be made as close as possible to the up-to-the-minute price you saw on your screen. You also want a broker who will be honest and ethical and not employ any of the many tricks of the trade for increasing their profits at your expense.
If you make the effort, you will find a broker or market maker who offers honest deals at reasonable spreads. Despite the huge volume of Forex trading (in the neighborhood of a few trillions daily worldwide among thousands of banks), it is still in some ways a small world. Word gets around and a bad reputation can ruin a broker.
Make sure you read the fine print and execute enough demo and small dollar volume trades to get used to Forex trading and how spreads affect your profits and losses. Forex trading is much more complex, volatile and fast-paced than even typical day trading in stocks. An educated investor will suffer fewer avoidable losses.
Forex Trading – Margin Calls, a Cautionary Tale
Let’s examine another sample trade.
The current ask price for EUR/USD is 1.1903. So the investor buys one euro (EUR) at the rate of 1.1903 dollars per euro. Trading one lot (100,000 units) means the investor pays 100,000 x $1.1903 = $119,030 and obtains 100,000 euros. The investor speculates that the euro is undervalued against the dollar, and turns out to be right. Now what?
EUR/USD is now listed at, let’s say, 1.1966/68. Since the investor owns euros, but wants to profit in dollars he now sells euros for dollars. Selling yields:
100,000 x $1.1966 = $119,660
The profit = $119,660 – $119,030 = $630.
Not bad for a day’s work, taking all of ten minutes. Of course, cockiness is unwise in currency trading, where rapid losses are just as quick to arrive as profits. But let’s be optimistic today.
The average investor often doesn’t have $100,000 or more to toss around. And one lot would be low in the world of currency trading where $20 million can change hands in the time it takes to make a mouse click. So, that’s where margins come in handy.
Suppose your broker offers a 1% margin. That means you put up 1%, the broker loans you the other 99%. Yes, that’s actually done, commonly. Your margin deposit is equivalent to 1,000 euros. 1% of $119,030 is 0.01 x $119,030 = $1,190.30. That’s the amount you actually invest to purchase one lot of euros at $1.1903.
When you sell, your margin is repaid and you receive the full $630, not 1% of $630 or $6.30. Since 1% = 1:100 you are leveraged 100 times over. In other words you receive the full 100 times $6.30 or $630. Whoever thought borrowing money could be so profitable!
So when purchasing 1 standard lot of 100,000 units of euros for $119,030 the investor has to provide only $1,1903 of his own cash. The broker provides the rest. Sweet deal!
But here’s what can go wrong…
You bought euros speculating that the euro was undervalued against the dollar. So you estimate the price of a euro (in dollars) will rise in the future, from 1.1903 to say 1.1906 and eventually it does. But before that happens the price falls, temporarily, to 1.1900. It loses ‘3 pips’.
Of course, at this stage no one knows how long ‘temporary’ is, nor whether the price will fall further or rise to your target selling price. Your broker, not knowing your credit worthiness or simply having bills of his own to pay, decides to cut his losses and liquidate your position. So he sells your euros for dollars and declares for you, without your prior knowledge or permission, a loss.
Brokers are entitled to do this, legally and ethically. They make no commission from you – they profit from playing spreads – and they are loaning you large sums of money for, in essence, zero interest.
Note, this is unlikely to happen on a drop of only three pips (we’re just keeping the numbers simple here), but it points to some important lessons.
Know your broker. You don’t have to be lifelong friends – they liquidate one another’s positions, too. But once you find a trustworthy and competent broker it’s desirable to keep them, rather than hopping to another the first time something isn’t done to your satisfaction.
That way, you’re more likely to receive a friendly warning call and you can shore up your position before the broker liquidates. No one likes surprise losses. Not that the others are welcomed, either. At minimum, you should be aware of the margin call policy.
Keep your credit healthy. If you don’t have enough capital to trade currency stick to stocks or mutual funds. Provide your broker with good reason to believe your credit is good so he’s not inclined to sell you out at the first sign of trouble.
Watch the market. Currency trading requires more diligence than stock or bond investing. Prices move quickly and large sums are involved. Currency prices are sensitive, even more so than other investments, to momentary political events, central bank pronouncements and other news items.
Those events are magnified by the fact that many countries are involved. Currencies trade in pairs, but professional traders are usually thinking of several different pairs at once. They watch euros against dollars and dollars against yen, playing small movements among pairs.
If you can’t pay attention, currency trading is not for you. That doesn’t mean you should be a day (or hour) trader in currency. That action is for the professional and they often lose money that way as well. They work for large banks and can afford to, temporarily. They have bigger pockets and will make it up tomorrow. But stay aware of your position.
Leverage is a terrific tool for the investor. But, as we’ve seen, there’s no such thing as a free lunch. Knowledge can keep you from getting eaten!
Forex Trading – Technical Indicators
Many of the common charts encountered in the toolkit of Forex traders are composed of a graphed series of technical indicators. So, in order to understand those charts, the student of Forex investing will do well to study those indicators.
Fortunately, it isn’t necessary to know exactly how to calculate them in order to use them. Software will do that for you. But, it’s helpful to have some idea of how they are arrived at, and what they mean, in order to evaluate their worth as trading tools.
Keep in mind, however, that none of the indicators – taken alone – tell the whole story. Nor do all of them together make one certain. Indicators are just that, they indicate. They do not predict with certainty. No mathematical tool used in Forex trading will do that. Beware of hyped promises.
Following are some of the more commonly used.
– Moving Average
Just as prices can be charted so can average prices. And, like the prices themselves, the averages change over time. The two most commonly calculated are the SMA (Simple Moving Average) and EMA (Exponential Moving Average).
The SMA is the average of prices taken at specified intervals, say an hour or a day. Each price is weighted equally in calculating the average. The more complicated EMA weights some prices more than others, on the premise that some are more relevant. Recent prices are considered more telling than those further back, hence these are weighted more in the calculation. For example, a 10-day EMA calculation will weight the last days more heavily than the first days.
Many software tools will indicate a buy signal when the current price rises above its moving average, since this suggests a rising market. A sell signal may be triggered when the price falls below the moving average.
– Bollinger Bands
Just as in futures and options trading, Bollinger Bands are a commonly used indicator. While their calculation involves some heavy-duty mathematics, their interpretation is considerably easier.
The bands are calculated as standard deviations above and below a simple moving average. The width of the bands will vary depending on volatility. As volatility rises, they become wider. As volatility decreases they narrow. Prices tend to stay within the upper and lower bands, with sharp price changes tending to occur after the bands tighten. If prices move outside the bands, the current trend will tend to continue.
A sell signal is suggested when the current price is above the moving average, close to the upper band. A buy signal is indicated when it moves to the lower band.
The RSI, or Relative Strength Index, is a value between 0 and 100. A number above 70 usually suggests that a currency is overbought and therefore due for a price reversal. A value below 30 indicates a currency is oversold.
As a price is making a new high, but the RSI fails to surpass its previous high, the trend is said to ‘diverge’. This often indicates an impending reversal of the trend. When the RSI dips below a recent bottom, it is said to have executed a ‘failure swing’. That move is seen as tending to confirm the impending price reversal.
There are several other common indicators, including MACD (Moving Average Convergence/Divergence), Momentum, OBV (On Balance Volume), Money Flow Index, Parabolic SAR, Stochastic Oscillators and dozens even more esoteric.
All these were developed as statistical tools to help predict prices and trends. But keep in mind that, though some technical analysts claim to eschew looking for causes, all of them are based on assumptions when used as technical indicators.
As with any tool, they should form part of a strategy for trading. They should not be used as a substitute for studying the market and using proper risk management.
Forex Trading – Line Graphs, Bar and Candlestick Charts
Today, every form of trading has become complex. Even in the (relatively) simple world of stock trading, it’s possible to become lost in a bewildering array of charts, diagrams and technical indicators. Nowhere is this more true than Forex trading.
Fortunately, many of the more or less standard indicators and charts used in stock, mutual fund or bond trading are used in Forex with minor adaptations. Buying and selling still involves monitoring prices and observing trends. That means that many of the statistical analyses used to do that are the same, regardless of the trading instrument being measured.
As with stock or bond trading, the simple line graph is still an enormously popular tool – popular because it is so helpful. In a simple form, current prices and the historical trend can be seen at a glance. The wrinkle in Forex trading is this: what do you mean by ‘the’ price?
Forex prices are always quoted for a pair of currencies. EUR/USD quoted at 1.2537/40 means that for $1.2540 you can buy one euro. To sell euros you own in exchange for dollars, you would receive 1.2537 dollars per euro.
Charts of these prices as they change over time are generated by calculations based on tools from technical analysis. Technical analysis involves the use of highly sophisticated statistical techniques to measure, calculate and predict likely price movements and directions.
A simple technical tool might be an average calculated over time. Note the price right now. Note it again an hour later. Repeat for 24 hours and average those numbers. All this, and much more, is typically done by software available from a wide variety of Forex brokers and online sites. That average represents ‘the price’ over an average trading day.
That one day average could be used as a single point on a line graph. Repeat the process at the same times for 30 days, plotting each point, and eventually you’ll build up a line graph of a 30-day moving average. The average itself will change over time, just as the price does. The change in that average over a 30-day period (or any other interval) gives an investor one insight into price changes.
In Forex trading, there are a dozen common calculations and charts. Some take two moving averages for different intervals – say, minute-by-minute measurements averaged over one hour compared to hour-by-hour averaged over 24 hours – and plots both on one graph. A number called the Moving Average Convergence/Divergence can then be used to compare those moving averages.
Fortunately, the average trader doesn’t have to understand the underlying mathematics in order to take advantage of these tools. Software, some downloadable to your desktop, others that operate directly within your browser, can be used to generate the charts. Some provide technical indicators, buy/sell signals and other useful information.
Still, understanding how to interpret these charts requires time and practice.
Beyond the simple line graph there are a few common charts that every Forex trader will want to learn how to use. Among these are the Bar Chart and the Candlestick Chart.
A bar chart displays prices in the form of a vertical ‘tick’ or bar, with small horizontal lines to the right and left. The ends of the bar indicate the high and low for some period, often the prior 24 hours. The left-facing tick is the opening price for that period, while the closing price is indicated by the right-facing tick.
A series of these bars can be graphed to form a bar chart for any time interval desired – daily, weekly, monthly, yearly and so on. Nor does the time period have to be opening and closing prices over a 24 hour period. They could just as easily be prices every hour, graphed over a day, a week and so on.
Candlestick charts are similar to bar charts, but contain additional useful information in graphic form. Originating in Japan, where they were used to track changes in agricultural futures contract prices, they have become part of the trading toolkit everywhere.
In addition to containing the information of a bar chart, they add color coding, by making the bar have a small width, hence its similarity in appearance to a candlestick.
The rectangle making up the ‘candlestick’ is called the body. A white (or, just as often, green) body indicates a closing price higher than the opening price. A black (or red) price indicates a closing price lower than the opening price. The lines protruding top and bottom from the body indicate the high and low prices at the tips.
Some candlesticks will have no line (or shadow as it is sometimes called) protruding from the top of body. That indicates that the currency closed at its high. Similarly, there may be no line protruding from the bottom. Such information is helpful in judging trends.
The length of the body, just as does the length of the bar in a bar chart, give a visual indication of the range of prices for that period. That is a visual measure of the volatility of prices, a very important factor in trading.
Candlesticks will form patterns as they are charted over time. Those patterns aid investors in making trading decisions. Those patterns have colorful names, such as the Hammer, the Hanging Man, the Morning Star and others. But though the names are fanciful, the purpose is serious: to help detect and predict trends.
Various patterns suggest trends that can be used as part of a trading strategy. Interpreting them, however, is part science, part art. The broker and software you select can help you understand them, provided you are willing to make the effort to study them over time.
Forex Trading – Pivot Points
A technical indicator called ‘Pivot Points’ is becoming increasingly popular. The usefulness of any single technical indicator is always up for debate. But one thing is certain: pivot points are a valuable idea and should be part of every Forex trader’s toolkit.
One possible reason pivot points have become so widely used is their sheer simplicity. Many indicators, such as Parabolic SAR or even Exponential Moving Averages, require some knowledge of fairly heavy duty mathematics to calculate. Many traders are reluctant to use an indicator that they only partly understand, and depth of understanding is only possible when you can calculate the indicator personally.
To calculate pivot points is simplicity itself. The formula is:
Pivot Point = (H+L+C)/3
where C is the currency pairs’ closing price for a given day, H is the high for the previous 24 hour period and L the low. In short, the pivot point is simply the arithmetic mean (the ‘average’) of the three prices.
Picking the time for C is somewhat arbitrary since Forex markets trade 24 hours per day. C is often measured at the New York Forex market closing time, 4 p.m. EST. This number, usually denoted P, is used in conjunction with several others – called resistance and support points – in order to form the basis of a trading strategy. The resistance and support points are also simple to calculate. The formulae are as follows:
R1 = (P x 2) – L
S1 = (P x 2) – H
R2 = P + (R1 – S1)
S2 = P – (R1 – S1)
Of course, how to choose a price for the resistance and support levels is key and traders differ, even though there is often a consensus. Some strategies select the pivot point itself as a point of support or resistance, depending on the direction of recent price movements. Others will choose the closing price of the previous day.
If the price moves above the pivot point, trending upward, the market is tending bullish and vice-versa. In the first circumstance the pivot point would be a point of resistance, since prices ‘resist’ moving above that level. In the latter case, it’s a support point.
Beyond attempting to evaluate trends, pivot points can be used as part of an entry and exit strategy. An investor might choose to place an order to purchase a currency pair if the price breaks through a resistance point.
Similarly, any good strategy will involve deciding in advance when to liquidate a position. Pivot points can be used to help select a stop-loss price in the event it moves below a support level.
No single indicator can be used reliably as the sole input to a good trading strategy. Pivot points, however, have been shown to perform well as part of an overall approach involving other indicators such as MACD (Moving Average Convergence/Divergence).
Owing to the enormous volume of transactions, currency prices are not much swayed by the action of any one trader, as is sometimes the case with stocks. That makes pivot points much more useful in Forex trading than in equity trading. Keep in mind, however, that such swings are possible as the result of central bank interest rate hikes, major political events and other fundamental factors.
Many analysts hold that pivot points achieve their useful status as a result of two tendencies.
If the day’s price begins above the pivot point, prices will tend to stay above that point until it reaches the first resistance point. Remember, ‘begin’ is a somewhat arbitrary point in time in Forex trading. Alternatively, if the price begins below the pivot point, it will tend to stay below that point until it hits a support point.
Sometimes called ‘trading between the lines’, this is one popular approach. Traders wait for the reversal of the trend off a resistance point, then sell. Similarly, when the price trends upward after bouncing off a support point, a buy order can be triggered. If the market trades near R2 or S2, prices will tend to move back toward the pivot point.
Of course, this approach has to be viewed with some skepticism, as most strategies should be. Resistance and support points are broken all the time – that’s what makes trading exciting. So, one has to wonder what makes those particular numbers resistance and support points.
To what degree those points influence trading decisions is a matter for debate. But, that they exist and have some influence is unquestionable.
It’s always difficult to judge when a price movement is a temporary correction versus the beginning of a trend. By the time the trend is clearly established, it is often too late to profit. As with any form of trading, there’s no substitute for experience as an aid to forming a sound, independent judgment.
Forex Trading – Forex Signals as a Trading Tool
Prices in Forex markets are the most volatile of any trading instrument. They change farther and faster (on average) than stocks and bonds, though commodities can be pretty roller coaster, too. This presents non-professional investors with a dilemma: either sit by a computer monitor all day, looking for price movements in real time or potentially lose a whole lot of money. But there’s a way out of that dilemma. Use signal services.
Forex signals are buy and sell indicators based on technical analysis. Technical analysis uses historical price and volume data to statistically analyze trends. The goal is to establish, with a stated probability, the likelihood of future price movements.
A signal could be as simple as ‘Buy euros now at 1.1901’. Those signals are delivered in any number of ways, by email, SMS text message to a cell phone, IM message and so on. Some are no more than flashing text and/or icons on trading software. The software contains in-built algorithms that use the methods of technical analysis, combines it with current market data and generates a signal.
For example, one commonly used technical indicator is something called MACD (Moving Average Convergence/Divergence). Without going into details here, it uses the moving average – the change in an average price over time. A signal can be generated when the value of MACD crosses above (or below) a certain threshold. Buy when it moves above the line, sell when it falls below.
Some signal services allow clients to automate the process of Forex trading even further. You can leave standing orders that when a certain signal is generated, carry out the recommendation. You get an email recommending ‘Buy euros now at 1.1901’ and the broker automatically enters an order to do just that.
As with any trading tool, it has to be used intelligently in order to avoid disasters. Entirely automating your buys and sells can amount to automatically losing money. Using a signal service can make your life easier, but never abandon your investments entirely to an automated service.
If you plan to do that, you may as well simply turn your investments over to a broker with the instruction: ‘Maximize my returns, but keep the risk down to a reasonable level’. Sensible, but not helpful if you want to control your destiny.
Signal services are definitely useful, however. They can relieve investors of the need to continually monitor prices. They can simplify the sometimes bewildering complexity of charts. They can help the investor make better decisions about when to buy or sell and at what price.
All that comes at a price, of course. Signal services range from $50-$250 per month, though some are cheaper and a few are more. Only the individual investor can decide whether the cost is justified. As with any trading service, if you make more than it costs than you would without it, that’s profitable.
But, buyer beware. There are dozens of firms that will be happy to take your money. Whether their analysis, and therefore, their signals, are worth anything is a learning experience all its own.
At minimum, investors should use order types that help control risk. Stop-loss orders, limit orders and other common types are an essential means of limiting losses and timing buy and sell orders. That technique, commonly employed in stock trading, is even more critical in the volatile world of Forex.
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